Underwriters are by no means embracing the residential class with open arms. But a determined few, mainly operating in the non-admitted market, have constructed policies to withstand claims leakage from prior years.

John Edack, an executive vice president for the Western region of Arch Insurance Group in San Francisco, went so far as to describe the current market for residential contractors and homebuilders as "robust."

"I think it's a healthy marketplace," he said, noting that residential contractors and builders are now able to find coverage that meets their requirements and those dictated by financial backers of construction projects. Insurance prices seem to fit into their overall budgets as well, he added.

But the class "is not for the faint of heart," he warned, noting that Arch entered 2002 with a qualified underwriting team, making a thorough application an integral part of the process. "There is potential for significant loss," he said.

Ten years ago, a California Supreme Court decision in Montrose Chemical Corp. vs. Admiral Insurance opened the floodgates to significant losses from construction defect claims. The ruling--which actually involved pollution cleanups at a chemical maker's facilities--rejected doctrines that previously stood as bars to coverage for claims from existing defects. Together with subsequent decisions, it put contractors' liability carriers on the hook for losses and defense costs on policies issued after the onset of continuing damage claims that took place over a number of policy periods--like leaky roofs.

"It seemed to immediately turn the market" for residential contractors in California, said William Newton, president of Lemac & Associates in Los Angeles.

Before Montrose, most risks were placed in the standard market, he noted. After Montrose, as business flowed to the surplus lines market, Lemac became a major player, and the wholesaler now has 40 percent of its operation in residential on the West Coast and in Hawaii, Mr. Newton said.

Lemac's markets include Mt. Hawley Insurance, a unit of Peoria, Ill.-based RLI Corp., with a program for small contractors doing residential repair work (under $1 million in sales), and seven insurers writing subcontractors for new tract homes.

Almost all those writing contractors involved in condominiums use wrap-up policies--purchased by an owner, developer, or general contractor to cover all parties involved in a project, he explained. "Arch took the lead in putting together a wrap-up program, and a few others followed them into the market," he said, noting that the wrap-up trend that started in California is moving across the country.

According to Ken Maskell, regional vice president for Arch, one benefit of a wrap-up from an insurer's perspective is that it reduces the possibility of cross-suits that exists when contractors and subs are covered under multiple policies.

Like Arch, ProBuilders Specialty Insurance--a Washington, D.C.-domiciled RRG--entered the residential construction market in 2002. "We capitalized on the market turmoil," said Peter Foley, president and chief executive, noting that a group of individuals--each with 20 years experience in construction--began working on the venture in 2001.

Focusing initially on the Western states, he said, market disarray in California caused by court rulings and a housing boom were factors that opened a huge market opportunity. ProBuilders now actively writes in 28 states and is registered in 49.

New York is the exception, Mr. Foley noted. "We're watching and deciding if we want to enter," he said.

In 2005, he predicts that the RRG will write close to $100 million, adding that nine homebuilders associations have endorsed the RRG. "Our focus in working with the associations is not to be the cheapest or the broadest in coverage, but to look for long-term relationships," he said.

In Mr. Foley's view, contract language and breadth of coverage are not the biggest issues for contractors. "Candidly, for many, the goal is 'Give me an insurance certificate, so I can get on that job site,'" he said.

Responding to that need, "we don't template-underwrite," he said, noting that the RRG will individually "risk-underwrite" most classes--including foundation, excavation, framing and roofing trades.

"If they know what they're doing, we'll look at them," he said, noting that the RRG's focus is on midsized contractors ($20-to-$25 million in revenues). ProBuilders also recently entered the multi-family townhouse and condo market with a wrap-up, entertaining subcontractors doing non-structural repairs.

While the focus in on the midsized contractors, Mr. Foley said a willingness to listen--for example, when a large shock loss hits a contractor with an otherwise good track record--has allowed the RRG to gain a presence in the $25-to-$50 million range. In one situation, he said, a big contractor wanted a large deductible, prompting a rejection from a usual market that viewed that as a credit risk.

He was located in a "homegrown community, where, if you foul up, you might as well move out of town," he said, going through some of the considerations that allowed the RRG to afford coverage. The contractor hadn't put a lot of assets in his company (to avoid being a target), but a look at his personal financials revealed the wherewithal to maintain a large deductible.

American International Group, with offerings of primary, excess and environmental policies, never left the residential contractors and builders market. "Obviously, there have been some issues associated with the insurability of these exposures," said Todd Germano, senior vice president of the Construction Specialty Excess Division. "I think AIG should get credit for having remained."

Noting that the excess unit writes in all states and entertains all classes, he said one change that allowed it to continue offering coverage for very large homebuilders was the development of a specialized coverage, referred to in the market as a "close-of-escrow policy." Coverage under the policy is granted only for homes that close within the succeeding 12 months.

At the time it was created, in 1999, the continuous trigger decision meant that homes built in prior years would be covered under previous occurrence-based policies. "If we didn't somehow stop the claims [from multiple-housing units built in prior years] from continuing into the next year, we would pick them up again. We were trying to avoid covering them twice," he said.

Heading up AIG's primary construction operation, Dan Conway, president of AIG Construction Risk Management, also said AIG responded to contractors' needs as the market tightened. But "we needed to protect ourselves--to keep ourselves out of the warranty business," he added, explaining that AIG imposed uncapped per-unit self-insured retentions to accomplish this.

AIG has begun to ease up on this recently. "As we progressed, and the quality of homes and documentation of homes improved, we became more comfortable with some--not all--who were in this business," he said, noting that this led AIG to start capping some self-insured retentions. He explained, for example, that a $25,000 per-dwelling SIR might now be capped at $500,000, as opposed to having no limit on the aggregate amount an insured retains.

At Zurich North America, getting closer to the warranty business was part of the carrier's strategy to participate in the "volume homebuilders market," according to Karen Schwartzkopf, senior vice president of the construction business unit in Minneapolis.

Zurich's sole product for the residential market--targeting homebuilders with annual revenues above $100 million and available with limits up to $25 million--came out in 1999, and is a blend of the homebuilders warranty and a liability policy.

The policy differs from an ordinary liability policy, according to Ms. Schwartzkopf, in that it includes coverage for "damage to your work" caused by construction defects under a warranty coverage part, and residual defect coverage available under the liability part. The warranty coverage is subject to arbitration.

With an average policy retention of roughly $1.2 million, the cost of maintenance-type repairs are usually "well within the insured's retention," she said. While "the intent is never to pick up the operation risk from a warranty standpoint," she stressed that understanding the warranty--and the customer service behind it--are key underwriting factors.

"We look at the upfront piece," she explained. "How well does that builder build a building? What is the quality-assurance, quality-control process? How do they document that? Then we look at the back-end--customer service. How well does the builder respond to warranty claims and service issues...so that those warranty claims don't eventually become defect claims."

The questions outlined by Ms. Schwartzkopf were repeated by every underwriter interviewed by NU.

At AIG, Mr. Conway said SIRs on primary policies will only be capped for contractors that "have very stringent quality-assurance programs [and who] are just as adamant about documenting." AIG underwriters get comfortable with this through face-to-face interviews, he noted.

"We like to visit the job sites," where contractors demonstrate "water penetration avoidance techniques [and] other quality-assurance issues--whether it's the drying of lumber or flashing around windows, the tagging process, or the documentation of the tagging in the different stages of completion of the home," he said, explaining that tags on construction details are initialed and dated to indicated they were inspected.

They "prove to us [that] it's not just an off-the-shelf-type program in a nice binder. We witness the program in action," he said.

Citing AIG statistics through 2004, he said that for every $1 of indemnity, there was $1.25 paid for legal expenses--underscoring the need for strong assurance programs, the benefit of a special AIG construction defect claims litigation unit, and the importance for contractors to aggressively monitor warranty processes.

"With a regimented process" that specifies timing of follow-up calls to homeowners and documents them, he said, "if a loss emanates six months later, there is evidence that you had called and there was nothing wrong."

"That's what it comes down to in many cases. It has nothing to do with the quality of the home, but it has a lot to do with the ability to defend one's home," he said.

Art caption:

Underwriters participating in the residential construction sector take an active stance in reviewing exposures--going out to job site to witness quality-control programs for themselves.

Caption, with Conway pix (if needed):

Dan Conway, president of AIG Construction Risk Management, said defense is critical for residential contractors and homebuilders. "In many cases, it has nothing to do with the quality of the home. But it has a lot to do with the ability to defend one's home," he said.